Swaps and Interest Rate Derivatives

International Corporate Finance

P.V. Viswanath

For use with Alan Shapiro “Multinational Financial Management”

P.V. Viswanath 2

Learning Objectives

To describe how interest rate and currency swaps works and their function.

To calculate the appropriate payments and receipts associated with a given swap.

To describe the use of forward forwards, forward rate agreements and Eurodollar futures to hedge interest rate risk.

To explain the nature and pricing of structured notes.

P.V. Viswanath 3

Interest Rate Swaps

Agreement between two parties to exchange dollar interest payments for a specific maturity on an agreed upon notional principal amount. No principal changes hands.

In a coupon swap, one party pays a fixed rate calculated at the time of the trade and the other side pays a floating rate that resets periodically against a designated index.

In a basis swap, two parties exchange floating interest payments based on difference reference rates.

The most important reference rate is LIBOR (London Interbank Offered Rate) – the average interest rate offered by a group of international banks in London for US dollar deposits of a stated maturity.

P.V. Viswanath 4

Coupon Swaps

Counterparties A and B both require $100 m. for a 5-yr period. A wants to borrow at a fixed rate, but B wants a floating rate. A can borrow floating at a reasonable rate, but not fixed; B can borrow fixed or floating at a good rate.

There is an opportunity for profitable exchange because the differences in the fixed rates across counterparties is different from the differences in floating rates.

If A borrows floating and B borrows fixed and they swap, both are better off, as long as A pays B a consideration of between 50 and 100 bps; in the next example, A pays B 75 bps, and 10 bps to an intermediary.

P.V. Viswanath 5

Coupon Swaps

P.V. Viswanath 6

Numerical Example of Coupon Swap

IBM issues a 2-year floating-rate bond, principal $100m. at LIBOR6 – 0.5% semiannually, first payment due end Dec. 2001

It enters into a swap with Citibank IBM pays Citibank an annual rate of 8% in exchange for LIBOR6. All payments are on a semiannual basis. Effectively, IBN has converted its floating-rate debt into a fixed-rate

bond yielding 7.5% In this case, Citibank has taken over the risk of the floating rate, which it

will either offset against other swaps in its book, or hold in return for the spread between a fixed 8% rate and a floating LIBOR6 - 50 bps. If this spread is large, given IBM’s credit risk, Citibank has a NPV > 0 transaction.

P.V. Viswanath 7

Numerical Example of Coupon Swap

P.V. Viswanath 8

Currency Swaps

A currency swap is an exchange of debt-service obligations denominated in one currency for the service on an agreed upon principal amount of debt denominated in another currency.

This is equivalent to a package of forward contracts. The all-in cost is the effective interest rate on the money raised.

This is calculated as the discount rate that equates the present value of the future interest and principal payments to the net proceeds received by the issuer.

The right-of-offset gives each party the right to offset any nonpayment by the other party with a comparable nonpayment.

In an interest rate swap, there is no need for a swap of principals, whereas this usually does occur in a currency swap.

P.V. Viswanath 9

Currency Swaps

P.V. Viswanath 10

Currency Swaps: An example

Dow Chemical and Michelin both want to borrow $200m. in fixed rate financing for 10 years.

Dow can borrow in dollars at 7.5% or in euros at 8.25% Michelin can borrow in dollars at 7.7% and in euros at 8.1%. Both companies have similar credit risks. This means that if

Dow wants to borrow in euros and Michelin in dollars, they could simply swap payments, so that Dow gets a euro borrowing rate of 8.1%, while Michelin gets a dollar borrowing rate of 7.5%.

Assuming a current spot rate of €1.1/$, we can compute the payments between the two parties.

P.V. Viswanath 11

Currency Swaps: An example

P.V. Viswanath 12

Interest Rate/Currency Swaps

We can combine interest rate swaps and currency swaps. Suppose Dow wishes to borrow euros, as before, but at a floating

rate. Dow can borrow euros at LIBOR + 0.35%, whereas Michelin can

borrow at LIBOR + 0.125% In this case, Dow will borrow fixed dollars and; Michelin will

borrow floating euros. Dow will make floating euro payments to Michelin, while

Michelin will make fixed dollar payments to Dow to enable each party to meet their interest rate commitments.

If they simply swap the payments, Dow will save 0.175% in interest costs, while Michelin, as before, will save 0.20%

P.V. Viswanath 13

Interest Rate/Currency Swaps

P.V. Viswanath 14

Interest Rate/Currency Swap

Kodak wishes to raise $75m. in 5 yr. fixed rate funds. Kodak issues an A$200m. zero-coupon bond issue at a net price of 53,

which realizes A$106m. Merrill enters into a swap agreement with bank A to swap A$70m. in 5 years

at a forward rate of $0.5286/A$1. Merrill enters into a zero-coupon/currency swap with bank B

Merrill makes the bank a zero-coupon loan in A$ at a rate of 13.39%. Merrill pays the bank A$68m. today and gets A$130 in 5 years.

The bank makes Merrill a floating rate $-denominated loan. Merrill gets $48m. and pays the bank a floating rate of LIBOR - 0.40% semi-annually and repays the $48m. in 5 years.

The initial payments are arranged so that they are equal in value.

Merrill partially hedges the LIBOR payments to bank B by entering into a $ fixed/floating swap with a notional value of $48m.

P.V. Viswanath 15

Interest Rate/Currency Swap

P.V. Viswanath 16

Interest Rate/Currency Swap

P.V. Viswanath 17

Interest Rate/Currency Swap

P.V. Viswanath 18

Economic Advantages of Swaps

Comparative Advantage (but this assumes market inefficiency). A firm might choose to issue floating and swap into fixed if has private

information that its credit quality spread will be lower in the future. Suppose a firm needs ten-year financing. However, it believes that the

market has overestimated its default risk currently, but that with new information, the market will realize this in six months.

One way to avoid committing itself to paying high interest rates for ten years, would be to issue short term debt; however, this would expose the firm to interest rate risk.

It could issue short term debt right away, say at LIBOR + 100 bp and simultaneously do a fixed-for-floating swap. Then, in six months time, it could issue a 9.5 year floating rate issue at a lower spread, say at LIBOR + 50 bp.

P.V. Viswanath 19

Economic Advantages of Swaps

Alternatively, it might believe that rates will increase and it is more sensitive than the market to interest rate changes; if so, it might issue floating debt and swap floating for fixed. The market will charge a premium for such a swap if rates are expected to increase; however, since the firm is more sensitive to rate changes than the market, this is a good deal.

Similarly, it would choose to swap a future payment in one currency for another if it believes that the second currency is going to appreciate in the future to a greater degree than believed by the market.

P.V. Viswanath 20

Interest Rate Forwards

A forward forward is simply a forward contract that fixes an interest rate today on a future loan.

A forward rate agreement separates the actual loan from the interest rate risk. It is equivalent to a forward forward, where the contract is “cancelled” at the date that the loan is to be initiated, and payments are made to make the losing party whole. Also, the risk of changes in borrower default risk are borne by the borrower.

Suppose Unilever has an agreement to borrow $50m. in 2 months for a duration of 6 months at a forward rate of 6.5% LIBOR. Two months later, actual spot LIBOR is 7.2%.

If Unilever did not have the agreement, it would have to pay 0.072($50m)(182/360) = $1.82m. in 6 months time. Because of the agreement, it need pay 0.065($50m)(182/360) = $1.64m only.

Hence there is a saving of (1.82-1.64)/(1+0.072(182/360)) = $0.17073m.

P.V. Viswanath 21

Eurodollar futures

Eurodollar futures are cash-settled futures contracts on a three-month, $1m. eurodollar deposit that pays LIBOR.

They are traded on the CME, the LIFFE and the SIMEX. They are effectively standardized FRAs. Unlike FRAs, futures contracts are marked to market at the

end of every day. In contrast, an FRA is marked-to-market only when the contract matures.

Furthermore, the notional value of an FRA is the amount to be “borrowed,” while the notional value in a eurodollar futures contract is the amount to be paid at maturity.

P.V. Viswanath 22

Eurodollar futures pricing

The price of a Eurodollar futures contract is quoted as an index number equal to 100 minus the annualized forward interest rate. If the current futures price is 91.68, the value of this contract at inception = $1m.[1-0.0832(90/360)] = $979,200, since 100-91.68 = 0.0832.

If the price rises to 100-7.54 = 92.46, the contract value rises to $1m.[1-0.0754(90/360)] = $981,150. Consequently, the buyer gets the difference of $1950 from the seller, right away.

Hence a basis point increase in the futures price is worth 1950/(9246-9168) = $25.

A firm intending to borrow money in the Eurodollar market in the future would sell a Eurodollar futures contract; one intending to lend money would buy.

P.V. Viswanath 23

Structured Notes

Interest bearing securities whose interest payments are determined by reference to a formula set in advance and adjusted on specified reset dates.

These factors can include LIBOR, exchange rates, commodity prices or any combination thereof.

FRN: interest payment tied to LIBOR. Inverse floater: interest rate moves inversely with market rates, e.g. nr –

(n-1)LIBOR, where r is the market rate on a fixed rate bond, with periodic rate resetting. The volatility is n times the volatility of a fixed rate bond.

Step-down notes: debt instruments with a high coupon in earlier payment periods and a lower coupon in later periods – for tax reasons, an investor might want to front-load his interest income.